Fortunately, I believe there is a way out of this dilemma: the Fed should adopt an explicit inflation objective and publicly commit to achieving that objective over some intermediate horizon. To me, the exact number or price index for the objective is somewhat less important than the public commitment to a goal. Such a commitment would help anchor expectations more firmly and diminish concerns of persistent inflation or persistent deflation — not an inconsequential issue in the current environment.

In addition to announcing an inflation objective, we must also clearly communicate our policy strategy to the public so that they understand how the FOMC anticipates achieving that goal. There are different ways to accomplish this. For example, Taylor-like rules that involve adjusting the federal funds rate in response to deviations of inflation from target and shocks to output or economic growth have some advantages. Such simple rules can be useful guides for conducting systematic policy and can help effectively communicate to the public the conditional nature of policy choices.

Over the longer-run, with appropriate monetary policy, I see both overall and core inflation averaging somewhere into the neighborhood of 2 percent, which is a rate I see as being consistent with price stability. That said, there is notable risk that inflation will remain a good deal below this range in the medium term.

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[A]t a time when near-term inflation is likely to be lower than usual, endorsing an explicit numerical objective for inflation could help keep inflation expectations from falling very far. Such an anchor on inflation expectations would help preserve low real inflation-adjusted interest rates.

An extensive body of literature suggests that communications can play a helpful role in addressing the zero-bound constraint. In particular, by offering guidance about the likely course of future short-term interest rates, conditional on the Committee’s economic forecast, the Fed may be able to influence longer-term rates and asset prices.  The Fed employed such an approach between 2003 and 2005, and has taken an important step along the same path in its December announcement by stating that “exceptionally low levels of the federal funds rate” are likely to be warranted “for some time” due to “weak economic conditions.”

Communication also can be important in the Fed’s efforts to anchor long-term inflation expectations. As I mentioned at the outset, the odds are high that over the next few years, inflation will decline below desirable levels.  It is especially important in such circumstances for the Fed to emphasize its commitment to returning inflation over time to the higher levels that are most appropriate to the attainment of its longer-term objectives. A decline in inflationary expectations when economic conditions are weak is pernicious, especially so when the federal funds rate has reached the zero bound, because any downdrift in inflation expectations leads to an updrift in real interest rates and a tightening of financial conditions.

I am not particularly concerned about the possibility of persistent deflation. When oil and commodity prices stabilize, the negative rates of inflation we have seen in the CPI are likely to disappear. Moreover, I am confident that the FOMC is committed to maintaining price stability. Nonetheless, we must act to ensure that expectations of deflation do not take root, just as we must act to ensure that expectations of higher inflation do not emerge. The failure to maintain well-anchored inflation expectations can wreak havoc with the real economy, foster unnecessary volatility, and make it more difficult for the Fed to deliver on its dual mandate to keep the economy growing with maximum employment and price stability.

I and others have long proposed establishing an explicit inflation target as one way to signal the FOMC's commitment to price stability and help anchor expectations. Such a commitment not only helps prevent inflation expectations from rising to undesirable levels, but it can also help prevent expectations from falling to undesirable levels.

I do not believe that deflation is a major risk right now. But deflation can be dangerous because for any given interest rate, it increases the corresponding real (or inflation-adjusted) interest rate, and thus stifles growth. For a sustained deflation to emerge, people have to believe that the money supply will fall along with the price level.  That's what happened during the first three years of the 1930s, at the beginning of the Great Depression, when the U.S. consumer price index fell by 27 percent, and the monetary base shrank by 28 percent. Central banks can prevent deflation by credibly committing to keep the money supply from contracting. Such a commitment is a natural byproduct of a credible commitment to price stability, but for a central bank that has not yet formally adopted an inflation objective, preventing deflation can present additional challenges. This is why some central banks increase the quantity of their monetary liabilities dramatically when interest rates are at zero — to convince the public they will not let the money supply contract in the future.

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred.

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Reflation--that is, a period of inflation above the long-run preferred rate in order to restore the earlier price level--proved highly beneficial following the deflations of the 1930s in both Japan and the United States. Finance Minister Korekiyo Takahashi brilliantly rescued Japan from the Great Depression through reflationary policies in the early 1930s, while President Franklin D. Roosevelt's reflationary monetary and banking policies did the same for the United States in 1933 and subsequent years.

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Eggertsson and Woodford (2003) have advanced a second argument for a price-level target for Japan in an important recent paper on monetary policy at the zero bound. These authors point out (as have many others) that, when nominal interest rates are at or near zero, the central bank can lower the real rate of interest only by creating expectations of inflation on the part of the public. Eggertsson and Woodford argue that a publicly announced price-level target of the type just described is more conducive to raising near-term inflation expectations than is an inflation target.